Xerium Technologies (NYSE:XRM) makes consumable products for paper manufacturers. They sell two broad types of products: paper machine clothing (two-third of revenues) and paper machine roll covers (one-third of revenues). Paper machine clothing is a specialty woven textile that helps guide the paper fibers through the paper machine while allowing water to drain out. Roll covers are generally rubber or polyurethane and cover the metal paper machine rolls that roll the paper fibers through the machine. Paper machine clothing has to be replaced every few months, while roll covers are replaced every 1-2 years.

Xerium is an industry leader in a consolidated, mature market. With 15% market share they are the number two player in paper machine clothing behind Albany International (AIN). They are the largest producer of roll covers with 33% market share.

XRM sales are tied to the level of global paper production. While the paper market is highly cyclical and also undergoing structural changes, in the big picture paper production should be a steady slow grower in line with global GDP. As a global maker of products that can be fitted to any paper machine, XRM is not tied to a specific geography or segment of the paper market. So they should be able to adapt to the shifting of paper demand growth from Western economies to Asia, as well as to the decline in newsprint and printing paper which should be filled in with growth in packaging and tissue papers.

XRM was hit hard in 2009 as paper production capacity was taken offline and customers drew down their consumables inventories. The slowdown combined with their highly leveraged balance sheet forced XRM into tripping their debt covenants. That led to a prepackaged bankruptcy in March 2010, which enabled XRM to reduce their debt load by $140 million. The business recovered strongly in 2010 and the stock hit $24 in April of 2011. Since then the stock has gone on a sharp downtrend to the current price under $7.

Revenues have rebounded since hitting a trough of $500 million in 09. They came in at $548 million in 10, and are at $586 million for the TTM, though still off 08 revenues of $638 million. There is a note of caution going forward as bookings in Q3 declined to $134.5 million from the $140-145 million range of the previous several quarters. Paper markets cooled off in the second half of the year, and XRM management was cautious on the Q3 call in regard to near term sales.

Gross margin has been more of a problem than the top line since emerging from bankruptcy. The bankruptcy plan projected gross margins in the 41% range, but they have been well under 40%, falling to 36.6% in Q3 11. That has been caused mainly by cost inflation in raw materials. Another factor is the higher percentage of products being sold into the higher-growth Asian markets, which are lower margin. Additionally, XRM does not yet have an extensive manufacturing presence in Asia so they bear higher shipping costs when selling there. XRM is trying to offset the margin decline by increasing sales of their “new products”, which have innovative or advanced technology features that they think can command higher margins. They have been successful in growing new product revenues, but it has not been enough to offset the margin erosion.

This chart is a nice summary of the recent EBITDA numbers (note adjusted EBITDA adds back stock comp and restructuring charges):

Turning to the balance sheet, XRM still has a large debt load even after the bankruptcy. They currently have $475 million of debt and $43 million in cash. XRM was able to refinance in May to push out maturities. They have $231 million of first-lien floating rate debt due in 2017, which they are currently paying 5.6% on. They have $240 million in senior notes at 8.875% due in 2018. The first-lien debt only has $2.4 million of amortization a year and at current levels XRM has about $35 million in annual cash interest. While XRM is levered almost 4X EBITDA, they should not have a problem servicing the debt. However, they do have a total leverage covenant of 4.75X total debt/adjusted EBITDA, which falls to 4.5X in June. If revenues weaken in the next quarter and gross margins stay low it is possible XRM could put up only $25 million in adj. EBITDA for the quarter. If the weakness persists for a few quarters then XRM would start to get close on the covenant.

Here is the current market valuation:

Looking at run rate EBITDA, management has noted the fourth quarter of 2010 saw exceptionally strong margins due to high demand as customers restocked after the XRM bankruptcy as well as some one time items. So it is probably more prudent to annualize the the first three quarters of 11 EBITDA of $82.6 million, which comes to $110.1 million annualized. That is an EV/EBITDA ratio of 4.9X. The close comp AIN trades at 5.7X, but AIN is much less levered. The more interesting story is the free cash flow to the equity. Current cash interest expense is about $35 million. Cash taxes are about $10 million. (XRM has NOLs coming out of the bankruptcy but they are in jurisdictions where they are not earning money so they have not been able to utilize them.) Management has guided to $30 million in capex in 2011. That leaves $38 million in FCF before working capital changes, or a 37% FCF yield:

A major caveat is that working capital has been a use of cash recently. Sales have been growing, but working capital has been rising faster as this chart shows (from XRM earnings release presentation):

This has hampered XRM’s ability to get cash out of the business and pay down debt. Management has targeted improved working capital management coming out of bankruptcy, but it has yet to manifest itself. TTM cash from operations before working capital changes is $63.1 million, but only $48.1 million with working capital changes. Sales were up $48 million over the prior period, but working capital was up $15 million. However, working capital did improve in Q3 and they were able to pay down $11.7 million of debt.

The potential investment thesis for XRM is pretty simple at the current market cap. If XRM can generate consistent free cash flow then value can accrue to the equity very quickly given the small size of their market cap in relation to their enterprise value and potential cash generation. At the current $6.75 a share price XRM market cap is $102 million. If they pay down $30 million in debt and hold the same enterprise value then the equity value increases 29%. As icing on the cake, the enterprise multiple might expand to something closer to AIN’s as the leverage profile moderates. Even one turn of EBITDA at these levels would more than double the price per share. Management has indicated their intent to delever and started the process in the last quarter. This slide from their October presentation seems to be indicative of their thinking (note the share price was higher at the time):

Of course leverage can cut both ways and XRM is tied to a volatile paper market. If the macro economy goes haywire then the things could get dire quickly once again for XRM. One difference this time around might be that customer inventories are not at the levels they were at before the 08 plunge, so a downturn might not hit sales as badly. And while they still do not have a great deal of breathing room on their debt covenants, in a potential breach they might get more relief from debt holders given their reduced overall debt levels as compared to the pre-bankruptcy period. I am very tempted by XRM, but for now I can’t get past the lack of stability in their markets combined with the high leverage.

Disclosure: No position

Elie Rosenberg runs a value investing research website at valueslant.com. Sign up here to get his free value investing ideas and analysis by email and get his free ebook,"16 Ways to Find Undervalued Stocks."

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